CM - Canadian Imperial Bank of Commerce: Buy A Safe Bank With A 6.2% Yield

2023-08-16 03:12:50 ET

Summary

• This is a defensive income investor play with plenty of share price upside.
• Canadian Imperial Bank of Commerce is a Canadian "DSIB" or Domestic Systemically Important Bank, well-monitored and safer than regional institutions.
• I estimate the current price of $41.68 is more than 20% undervalued.
• Dividends have doubled since 2010, and the payout ratio remains low.
• The Tier 1 capital ratio is 13.4%, far above the FDIC guideline of 8.0%.

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Canadian Imperial Bank of Commerce ( CM , CM:CA ) is the fifth-largest bank in Canada by assets, but its shares have suffered the fate of much of the banking sector since the March bank crisis. The current price of US $41.68 (at the time of writing) is down 34.1% from the February 2022 peak of $63.21. With all the uncertainty today, it seems like a tough time to consider banks stocks as an investment. But CIBC's dividend is now 6.2% and I believe the shares are significantly undervalued at the current price. CM is one of six Canadian retail banks that collectively hold 90% of Canada's bank deposits. It is one of the most Canada-focused of this group and right now this is probably a good thing.

Please note: All currencies are denominated in CAD, unless otherwise stated.

Systemic Risks With Rates Rising

Late Monday, Moody's Investors Service lowered its ratings for 10 small banks and said it may downgrade some large banks including U.S. Bancorp (USB), Bank of New York Mellon (BK), and State Street (STT). Eleven others were revised to negative outlook; see Moody's Banks Get Downgraded . Clearly the banking system is not out of the woods yet.

In early March, we had the failures of Silicon Valley Bank (SIVBQ), Signature Bank (SBNY), and then in May the failure of First Republic Bank (FRC) - a warning shot about the regional banking system. All three had over 80% of their depositors with more than US $250,000 in the bank, the FDIC insurance limit. At SVB uninsured deposits were actually 93.8%, see S&P Global for an uninsured deposit list. When interest rates rose quickly last year, the value of existing assets like Treasury notes and mortgage loans fell, as new versions were issued at much higher rates. Because of this, these banks were in a negative capital position, with unrealized losses exceeding 30% of their Tier 1 Capital, causing savvy depositors to panic over their uninsured accounts. When they withdrew their funds, there weren't enough assets left to make everyone whole, or to cover the losses, forcing the FDIC to step in. All three institutions were victim to an old fashioned run on the bank.

The toxic formula that created this problem was a combination of unrealized losses as a high percent of Tier 1 Capital (for SVB and friends, over 30%), combined with high rates of uninsured deposits. This is illustrated in the chart below.

CIBC's Fundamentals

I believe that CIBC is not exposed to these systemic risks, even with interest rates rising. I'll explain why throughout this article. According to its 2022 annual report, CIBC has 13 million clients and $6.2 billion in net income. Total assets are $943.5 billion. CIBC is not a regional bank, but a national one with 1,100 branches throughout Canada.

The last three years were good ones for CIBC. Revenue increased from $18.6 billion in 2019 to $20.0 billion in 2021, then $21.8 billion in 2022. This was primarily due to volume growth and higher fee income on domestic accounts. Fees grew from $8.5 billion in 2021 to $9.1 billion in 2022, see 2022 Annual Report . The bank has increasingly focused on its retail operations and this has paid off. It has also been able to reduce its non-interest expenses in each of the last three years. Earnings per share grew from $4.11 in 2020 to $6.68 in 2022, an increase of 62.5%. The bank is also seeing improved growth from its U.S. operations, which now contribute over 20% to earnings.

Second quarter 2023 results were generally strong. The net interest margin (interest income generated versus paid on deposits) was 3.41%, down slightly from 3.54% last quarter, and up from 3.39% a year ago, mainly due to higher deposit margins. See CIBC's Second Quarter Report . The average across US banks was only 2.95% as of the second quarter. While the rising interest rate environment is starting to level off, CIBC expects a modestly positive impact on the net interest margins for all its business units. Second quarter revenue was $5.702 billion, up 6.0% from $5.376 billion the prior year. Quarterly net income was $1.688 billion, up from $1.523 billion the year before, a change of +10.8%. Return on equity was 14.5%. Cash on hand was $53.3 billion versus $63.8 billion a year ago, primarily due to lower short-term placements in Treasuries.

So how does the dangerous blend of unrealized losses as a high percentage of Tier 1 Capital and the rate of uninsured deposits apply to CIBC? Unrealized losses as of Q2 2023 were reported as $437.0 million and they were $619.0 million at the end of 2022. Unrealized losses were only $101 million at end of 2021, but this is to be expected in a rising interest rate environment. Tier 1 Capital was $43.1 billion at the end of the second quarter (see the table below), so unrealized losses were only 10.1% of Tier 1. At the end of 2022 they were 14.8%. So the ratio of unrealized losses to Tier 1 is now declining.

As of the second quarter 2023, about 65% of deposits were uninsured, see Reuters article . The Canadian Deposit Insurance Corporation ((CDIC)) insures bank deposits up to $100,000, as long as they are held in member banks. But right now there is serious talk of raising that number to $200,000, which would reduce the rate of uninsured deposits at CIBC significantly.

Besides the low rate of unrealized losses at CIBC, I believe the structure of Canada's banking system makes for a more stable financial environment.

Canada's Regulatory System, Stability and DSIBS

Canada's banking system is more regulated than that of the US and barriers to entry are very high. It is structured to favor large banks, where fixed costs are spread across a larger operating base, and risk is lower. Banks in Canada can only carry out banking activities; trusts, securities, and insurance must be done through wholly owned subsidiaries, not through the bank. Non-Canadians cannot own more than 25.0% of any bank's shares, and foreign banks can only operate in Canada only under limited conditions.

Canadian regulators focus primarily on the big six Canadian banks (the "Domestic Systemically Important Banks" (D-SIBs), where 90.0% of the country's deposits are held. This includes CIBC, as well as RY and TD. These banks are the most geographically diverse, with branches across the country, spreading out credit risk. Canada's government requires these six banks to have a "Domestic Stability Buffer ((DSB))," so they can easily adjust to vulnerabilities and system-wide risks as they arise. This is a capital buffer they must set aside to be able to cover losses. It is currently 3.50% of the bank's total risk-weighted assets.

Dividend History

CIBC hasn't missed a regular dividend since its first dividend payment in 1868. During the 2008-2010 financial crisis, it did not raise its dividend, but it did not cut it either. During that period the bank weathered large loan write-downs related to real estate. Since then, it has increased its quarterly dividend from $0.435 to $0.87, an increase of 100.0%. CIBC's 2022 annual report states, "The Company is committed to maintaining a strong dividend." Payout ratios are generally below 50.0% as shown below by year.

Share Valuation

I estimate the current value of CIBC share to be US $56.61. I have used a DCF to value the company's shares. This involved taking the earning per share, beginning year end 2022, the most recent full year, then projecting forward. In this case, I have used a 5-year projection period rather than 10 years, because it is easier to make estimates over a short time period. To do this calculation, I need a discount rate to adjust for time and risk, a growth projection for earnings per share over the next 5 years, and a capitalization rate for converting income in the next year into a perpetuity.

Below are CIBC's annual earnings since 2018. All figures are in Canadian Dollars. Between 2018 and 2023, the compound annual growth rate in earnings was 3.7%.

Net income in 2020 was affected by several onetime charge offs including a $339 million restructuring charge for management downsizing, and a $248 million goodwill impairment charge related to the bank's controlling interest in CIBC First Caribbean. Earnings rebounded in 2021 and 2022.

I have valued the shares using CIBC's net income of $6.68 in 2022, then the analyst consensus projections for $7.00 per share in 2023, with a low 1.0% growth rate in net income each year over the next five years and a 10.0% discount rate. The exchange rate used is one Canadian Dollar = $0.75 US Dollars. The current P/E ratio for CIBC is 10.5. The inverse of the P/E ratio is a cap rate, so 1/10.5 = 0.95 or 9.5%. From this, I have estimated a reversion rate of 9.5%. For a discount rate, I have looked to the average annual return of the S&P 500. The long term average is about 9.25% while over the last 10 years it has been 10.4% (source) . I have elected to use a discount rate of 10.5%, at the upper end of the range, discounting beginning in the second year. Yes, all of this is estimated and based on art rather than precision. And for that reason I have valued the company very conservatively.

Again, I estimate the value of the shares listed on the NYSE to be worth US $56.61. They are being discounted significantly along with the rest of bank shares in the market today due to systemic risk. However, the Moody's warning and dire forecasts will not impact CIBC and if the market moves down, it will only make the shares more attractive.

Risks To Outlook

Today, CIBC does have a high exposure to Canadian home mortgages, which creates some uncertainty in a rising interest rate environment. The Bank of Canada recently raised its overnight interest rate by 25 basis points to 5%, its highest level in 22 years. However, write offs in the Canadian mortgage market have historically been low due to the non-deductibility of mortgage interest and the generally low loan-to-value ratios of borrowers. Below is the Bank of Canada's main policy rate history, and recent statements indicating the bank expects inflation and spending to slow, see current Policy Report . Easing the pace of rate increases will mitigate risk to CIBC's mortgage portfolio.

Conclusion

CIBC certainly appears to currently be at a below market price, with a very low level of risk due to rising interest rates. Shares have been punished with the rest of the banking system, even though the possibility of a run or instability is much lower, despite warnings about the banking system from Moody's. I believe this to be the case because:

• Unrealized losses as of the second quarter were only 10.1% of Tier 1 capital, a number that is going down.
• Tier 1 capital is at 13.4% and the bank has an extra "domestic stability buffer" of 3.5% of risk-weighted assets.
• Uninsured funds are 65.0% of all deposits, a number likely to go down when and if CDIC raises the insured amount to $200,000.
• CIBC is a "DSIB" or Domestic Systemically Important Bank, safer than a regional institution.
• Shares appear more than 20% undervalued based on a DCF valuation.

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